Author: indiafreenotes

Corporate Governance is a mechanism based on certain systems and principles by which a company is governed. The governance ensures that a company is directed and controlled in a way so as to achieve the goals and objectives which include providing benefits to the stakeholders like shareholders, employees, suppliers, customers and society in the long term and adding value to the company. It is actually conducted by the board of Directors and the concerned committees for the benefit of stakeholders’ company’. Corporate governance is all about balancing individual and societal goals as well as economic and social goals.

The Companies Act, 2013

The new Companies Law contains many provisions related to good corporate governance like Composition of Board of Directors, Admitting Woman Director, Admitting Independent Director, Directors Training and Evaluation, Constitution of Audit Committee, Internal Audit, Risk Management Committee, SFIO Purview, Subsidiaries Companies Management, Compliance center etc.

All such provisions of new Companies Law are instrumental in providing a good Corporate Governance structure. Few provisions are:

Section 134:

It mandates to attach a report to every financial statement by Board of Directors containing all the details of the matter including the statement containing director’s responsibility.

Section 177:

It requires Board of Directors of every listed company or any other class of committee to constitute an Audit Committee. It also provides the manner to constitute the committee.

Section 184:

It mandates the Director disclose his interest in any company or companies, body corporate, firms, or other association of Individuals. The director is required to disclose any such interest at the first meeting of the board and if there is any change in the interest, then the first meeting will be held after such change.

Securities and Exchange Board of India (SEBI)

SEBI is a regulatory authority established on April 12, 1992 with the main purpose of curbing the malpractices in the financial market and protecting the interest of its investors. Its main objective is to regulate the activities of Stock Exchange and to ensure the healthy development in the financial market. In order to ensure good corporate governance, SEBI came up with detailed norms of Corporate Governance.

• As per the new rules, the companies are required to get shareholders’ approval for RPT (Related Party Transactions), a provision for whistle blower mechanism, clear mandate to have at least one woman director in the Board and moreover it elaborated disclosures on pay packages.
• Clause 35B of the Listing Agreement is being amended by the regulatory authority. Now as per the amended clause, listed companies are required to provide the option of e-voting to its shareholders on all proposed or passed general meetings. Those who do not have access to e-voting facility, they should be entitled to cast their votes in writing on Postal Ballot. The amended provision was needed so that the provisions of the listing agreement can be aligned with the provisions of Companies Act, 2013. By doing so, a closer step is provided to strengthen the Corporate Governance norms in India with respect to listed companies.
• Clause 49 of the Listing Agreement was also amended by SEBI in order to strengthen the Corporate Governance framework for listed companies in India. The revised clause forbids the independent directors from being eligible for any kind of stock option. Whistle blower policy is also added in the revised clause whereby the directors and employees can report any unethical behaviour, any fraud or if there is violation of Code of Conduct of the company.

With the amended provision, Audit Committee is also enhanced, now it will include evaluation of risk management system, internal financial control and will keep a check on inter-corporate loans and investments. The amendment now requires all the companies to form a policy for the purpose of determination of ‘material subsidiaries’ and that will be published online.

Standard Listing Agreement of Stock Exchanges

The Listing Agreement is the basic document which is executed between companies and the Stock Exchange when companies are listed on the stock exchange. The main purposes of the listing agreement are to ensure that companies are following good corporate governance. The Stock Exchange on behalf of the Security Exchange Board of India ensures that companies follow good corporate governance.

The Listing Agreement comprises of 54 clauses stating corporate governance which listed companies have to follow and in case of failing to such, companies have to face disciplinary actions, suspension, and delisting of securities. The companies also have to make certain disclosures and act by the clauses of the agreement.

Secretarial standards issued by ICSI (Institute of Company Secretaries of India)

It is an autonomous body constituted by the Company Secretaries Act, 1980. It is a body to regulate and develop the profession of Company Secretaries in India. It issues secretarial standards as per the provision of the Companies Act, 2013.

Section 118(10) of the Companies Act states that every company shall observe secretarial standards specified by Institute of Company Secretaries of India with respect to General and Board meetings.

• Secretarial standard-1 on Meeting of the Board seeks to prescribe a set of principles for conducting meetings of Board of Directors. These principles are equally applicable to the meetings of committees as well. SS-1 principles are applicable to the Meeting of Board of Directors of all companies except one Person Company.
• Secretarial standard-2 prescribes a set of principles for conducting and convening general meetings. This standard also deals with the procedure for conducting e-voting and postal ballot. SS-2 is applicable to all types of General meetings of all companies except one Person Company incorporated under the act. The principles in SS-2 are applicable mutatis-mutandis to meetings of creditors and debenture holders. Moreover, it also prescribes that any meeting of members or creditors or debenture-holders of a company under the direction of CLB (Company Law Board), NCLT (National Company Law Tribunal) or any other authority shall be governed by the provisions of this standard.

Eight Codes of Corporate Governance

Governance Structure:

All organizations should be headed by an effective board and all the responsibilities and accountabilities within the organisation should be clearly distinguished.

Structure of the Board and its Committees:

The board should consist of appropriate combination of executive directors, independent directors and non-independent non-executive directors to prevent one individual or a small group of individuals from dominating the board’s decision. The board’s size and scale should be in proportion with the level of diversity of the organisation. Appropriate board committees may be formed to assist the board in effective performances to fulfil the duties.

Director’s Appointment Procedure:

There should be a formal, rigorous and transparent process for various activities like appointments, election, re-election of directors etc. Members for the board should be appointment on merit basis fulfilling objective criteria which should include skills, knowledge, experience, and independence for the benefits of the company. The board should ensure that a formal, rigorous and transparent procedure be in place for planning the succession of all key officeholders.

Directors’ duties, remuneration and performance:

Directors should be aware of their legal duties. They must observe and foster high ethical standards and a strong ethical culture in their organisation. Each director must be able to give sufficient time to discharge his or her duties effectively. Conflicts of interest should be disclosed and managed.

The board of members is responsible for the governance of the organisation’s information, information technology and information security. The board, committees and individual directors should be supplied with informations in a timely manner and in an appropriate form and quality. The performances of board members should be evaluated and be held accountable to appropriate stakeholders. The board should be transparent, fair and consistent in determining the remuneration policy for directors and senior executives.

Risk Governance and Internal Control:

The board will be held responsible for risk governance. It must check the development and execution of a comprehensive and powerful system of risk management and also ensures the maintenance of a sound internal control system.

Reporting with Integrity:

The board must present a fair, balanced and understandable assessment of the performances and outlook of organization’s financial, environmental, social and governance position in its annual report and on its website.

Audit:

All the organizations should consider having an effective and independent internal audit function that has the respect, confidence and cooperation of both the board and the management. The board should establish formal and transparent arrangements to appoint organisation’s auditors and maintain an appropriate relationship with them.

Relations with Shareholders and other key Stakeholders:

The board should be responsible for ensuring that an appropriate interchange and disclosure takes place between the organisation, its shareholders and other key stakeholders. The board should respect the interests of its shareholders and other key stakeholders within the context of its fundamental purpose.

The Securities Contracts (Regulation) Act, was enacted in the year 1956. It is also referred to as the SCRA and is one of the first few rules and regulations or legislations made in the Indian capital markets.

The SCRA regulates the contracts executed in the Indian securities markets and stock exchanges. Therefore, all those securities that are defined by the Securities and Exchange Board of India (SEBI) have to necessarily follow the terms and conditions specified under the securities contract or the SCRA.

Important Definitions

Contract means a contract for or relating to the purchase or sale of securities.

Corporatisation means the succession of a recognised stock exchange, being a body of individuals or a society registered under the Societies Registration Act, 1860 (21 of 1860), by another stock exchange, being a company incorporated for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities carried on by such individuals or society.

Demutualisation means the segregation of ownership and management from the trading rights of the members of a recognised stock exchange in accordance with a scheme approved by the Securities and Exchange Board of India.

Derivative includes:

(i) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security,

(ii) A contract which derives its value from the prices, or index of prices, of underlying securities,

(iii) Commodity derivatives, and

(iv) Such other instruments as may be declared by the Central Government to be derivatives.

Non-transferable specific delivery contract means a specific delivery contract, the rights or liabilities under which or under any delivery order, railway receipt, bill of lading, warehouse receipt or any other documents of title relating thereto are not transferable.

Scheme means a scheme for corporatisation or demutualisation of a recognised stock exchange which may provide for

(i) The issue of shares for a lawful consideration and provision of trading rights in lieu of membership cards of members of a recognised stock exchange,

(ii) The restrictions on voting rights,

(iii) The transfer of property, business, assets, rights, liabilities, recognitions, contracts of the recognised stock exchange, legal proceedings by, or against, the recognised stock exchange, whether in the name of the recognised stock exchange or any trustee or otherwise and any permission given to, or by, the recognised stock exchange, (iv) the transfer of employees of a recognised stock exchange to another recognised stock exchange; and (v) any other matter required for the purpose of, or in connection with, the corporatization or demutualisation, as the case may be, of the recognised stock exchange.

Securities include

(i) Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate,

(ii) Derivative,

(iii) Units or any other instrument issued by any collective investment scheme to the investors in such schemes,

(iv) Security receipt as defined in clause of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act,

(v) Units or any other such instrument issued to the investors under any mutual fund scheme,

(vi) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be,

(vii) Government securities,

(viii) Such other instruments as may be declared Government to be securities, and

(ix) Rights or interests in securities.

Specific Delivery Contract means a commodity derivative which provides for the actual delivery of specific qualities or types of goods during a specified future period at a price fixed thereby or to be fixed in the manner thereby agreed and in which the names of both the buyer and the seller are mentioned.

Spot Delivery Contract means a contract which provides for,

(i) actual delivery of securities and the payment of a price therefor either on the same day as the date of the contract or on the next day, the actual period taken for the despatch of the securities or the remittance of money therefor through the post being excluded from the computation of the period aforesaid if the parties to the contract do not reside in the same town or locality.

(ii) Transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository.

Transferable Specific Delivery Contract means a specific delivery contract which is not a non-transferable specific delivery contract and which is subject to such conditions relating to its transferability as the Central Government may by notification in the Official Gazette specify in this behalf.

Recognized Stock Exchange

 Any stock exchange that desires to be recognized under this Act can apply to the Central Government in the prescribed form along with a list of particulars that include:

• The governing body of such stock exchange, its constitution, and powers of management and the manner in which its business is to be transacted,
• The powers and duties of the office-bearers of the stock exchange,
• The admission into the stock exchange of various classes of members, the qualifications for membership, and the exclusion, suspension, expulsion, and re-admission of members therefrom or thereinto, and
• The procedure for the registration of partnerships as members of the stock exchange in cases where the rules provide for such membership; and the nomination and appointment of authorized representatives and clerks.

Powers granted by the SCRA

• Granting recognition to stock exchanges
• Withdrawing recognition given to stock exchanges
• Power to call for periodical returns and conducting direct inquiries
• Power to require the furnishing of annual reports of recognised stock exchanges
• Power to make rules and to direct rules to be made
• Power to supersede governing body of a recognised stock exchange
• Power to suspend the business of recognised stock exchanges
• Power to notify contract as illegal in certain circumstances in notified areas
• Power to prohibit contracts in certain cases
• Power to license dealers in securities in certain areas
• Power to grant immunity
• Power to delegate its powers to the Securities and Exchange Board of India and the Reserve Bank of India
• Power to make rules
• Power to vary or set aside the decision of refusal to list securities made by the recognised stock exchange on appeal
• Power to grant or refuse listing of securities in appeal

Powers granted to the Securities and Exchange Board of India (SEBI) by the SCRA:

• Power to approve the transfer of duties and functions of a clearing house to a clearing corporation
• Power to approve the making of bye-laws by recognised stock exchanges for the regulation and control of contracts
• Power to make or amend bye-laws of recognised stock exchanges
• Power to issue directions to stock exchanges, clearing corporations, agencies, persons or classes of persons associated with the securities market
• Power to issue directions to companies whose securities are listed or proposed to be listed in a recognised stock exchange
• Power to approve the establishment of additional trading floor in recognised stock exchanges
• Power to appoint adjudicating officers
• Power to make regulations

Powers granted to the Securities Appellate Tribunal by the SCRA:

• Power to summon and enforce the attendance of any person and examine him on oath
• Power to require the discovery and production of documents
• Power to receive evidence on affidavits
• Power to issue commissions for the examination of witnesses or documents
• Power to review its decisions
• Power to dismiss application for default or deciding it ex- parte
• Power to set aside any order of dismissal of any application for default or any order passed by it ex- parte
• Power to vary or set aside decision of refusal to list securities made by the recognised stock exchange on appeal
• Power to grant or refuse listing of securities in appeal
• Power to exercise any other prescribed matter

Penalties under the SCRA

The offenses and penalties under the SCRA include:

Corporate governance is a system by which corporates are directed and controlled. The Board of Directors have a fiduciary duty to the shareholders, and thereby are responsible for overseeing the operations and activities of the company. Corporate governance also provides the framework for the attainment of a company’s objectives. The main focus is to make the business function in a highly effective manner so as to achieve positive results and thereby maximise the returns of the stakeholders.

Principles of Corporate Governance

Transparency

The more informed you are, the more certain you are. This is the mantra that the stakeholders firmly believe in. Transparency, in the business world, also pays dividends. Companies that are upfront about the goings-on in the operations and with regard to their financials earn the public trust, something that is immeasurable.

Transparency is an essential component at all levels of operation in a business entity; especially at the top management level, where major decisions are made and where major plans are formulated. Keeping the investors and other stakeholders informed helps build a relationship of trust and solidarity those results in the rewards of a higher valuation and easy access to funding.

Accountability

Accountability, in essence, means willingness or an obligation to accept responsibility for one’s actions. Accountability is generally looked at from a negative viewpoint and misconstrued by many who think it is associated with the traditional “Blame Game”. In reality, accountability answers more questions than just the one regarding who the responsible person is. It has to be looked at from a positive standpoint as well because it recognises accomplishments too.

Accountability gives the shareholders confidence in the business that, in any case, that leads to an unfavourable situation in the company, the ones responsible are dealt with in an appropriate manner. Accountability establishes a system in place where everyone is held accountable for their respective work and associated duties. Accountability holds two main things firmly in place:-

• Ensures that the management is accountable to the Board.
• Ensures that the Board is accountable to the shareholders.

Independence

The ability to make decisions while being free from any sort of constraint or without any influence is what independence is. And this is something that has proven to be crucial to the smooth operation of businesses as well. Independence is:

• The ability to stand firm in the face of inappropriate influences.
• The ability to make unadulterated, firm decisions on any given issue
• The ability to adhere to professionalism and do right by the company

It allows the person to act with integrity and make decisions and form judgments bearing in mind the best interests of the stakeholders. This is the reason companies appoint independent directors, so as to ensure that there is no force of hand being used or that the director does not have any personal interests with the company thereby hampering his ability to make decisions freely.

Principles of Corporate Governance

Leadership: The board of directors and the CEO should be competent in decision-making.

Risk Management: There should be a robust risk management mechanism for handling uncertainties.

Responsibility: The board of directors is responsible for running the business on behalf of the shareholders.

Fairness: All the stakeholders should be treated equally.

Effectiveness and Efficiency: The policies and procedures should be clear and uniform. Moreover, it should be well-communicated.

Principles, OCED Principles of corporate governance:

In addition to shareholders, crucial information should also be communicated to vendors, customers, financers, and employees.

Promote ethical and responsible decision-making

The Board ensures that the Bank promotes ethical and responsible decision-making and complies with all relevant policy, laws, regulations and codes of best business practice using the Group’s ethics and operating principles. The ethics and operating principles address the following matters: conflicts of interest, corporate opportunities, confidentiality, fair dealing, protection of and use of the Group’s assets, compliance with laws and regulations and encouraging the reporting of unlawful/unethical behaviour.

Advantages of Corporate Governance

Good corporate governance can turn a good company into a great one. The leaders in any industry are at the helm of their respective industries, mainly because of outstanding corporate governance practices.

Lesser fines and penalties: Since the legal compliance aspect is taken care of credit to the corporate governance practices, companies are able to save a fortune on unnecessary fines and compliances and possibly redirect those funds towards business objectives to achieve greater heights.

Compliance with laws: With corporate governance in place, compliance with various laws is taken care of easily, as corporate governance includes the rules, regulations and policies that enable a business to stay compliant throughout and function without any hassle or legal inconveniences whatsoever.

Better management: Since there is a structure in place with regard to how the entity operates, its day-to-day functioning, managing the activities and achieving targets becomes a whole lot easier. The work atmosphere also takes care of itself under good principles of corporate governance fostering teamwork, unity, efficiency and a drive for success.

Lesser conflicts and frauds: The rules instilled in the workplace encourage the employees to be morally conscious in every situation that they encounter, thus eliminating the possibility of fraud and conflict between employees.

Reputation and relationships: Companies with good corporate governance are able to attract investors and external financiers with relative ease, going by their sterling reputation and brand image. One of the pillars of corporate governance is transparency, which is the practice of sharing key internal information with the stakeholders. This improves the relationship of the entity with its stakeholders and sows the seeds of trust between the company and society at large.

Disadvantages of Corporate Governance

When it comes to the matter of smaller corporations, there might be a bit of hassle where the shareholders may serve as the directors and managers, having no segregation as such. Bearing this in mind, it gives rise to:

Increased costs: Administrative costs for companies with corporate governance are pretty exorbitant, considering all the requirements to be met. Here are a few documents to be maintained:

Stock sales and purchases > Legal compliance records > Annual registration

The burden of staying legally compliant: Corporates generally have loads of compliance that have to be followed, attracting different laws based on their industry. Corporate governance ensures legal compliance, but it does come at a very hefty price.

The conflict between the principal and the agent: Large corporations have made it a common practice to appoint a well-known manager, one with a good track record to manage the day to day operations of the business. Unfortunately, this gives rises to a conflict between the shareholders and the managers as they both may have very different objectives and perspectives. This often leads to a clash between the two, thus affecting the overall ability of the business to run its operations in a smooth and efficient manner.

Maintenance of segregation: Irrespective of the size of the corporation, the adherence to all formalities and requirements must be met without any exceptions. Failure to comply with these rules leaves the company with huge exposure such as “piercing of the corporate veil”, where the separate legal entity status of the corporation is ignored in order to understand the goings-on behind the closed doors.

OECD Principles of Corporate Governance

The six OECD Principles are:

• Ensuring the basis of an effective corporate governance framework
• The rights and equitable treatment of shareholders and key ownership functions
• Institutional investors, stock markets, and other intermediaries
• The role of stakeholders in corporate governance
• Disclosure and transparency
• The responsibilities of the board

1. Ensure the basis of an effective corporate governance framework

The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

2. The rights and equitable treatment of shareholders and key ownership function

‘The corporate governance framework should protect and facilitate the exercise of shareholders’ rights and ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.’

Basic shareholder rights should include the right to:

• Secure methods of ownership registration;
• Convey or transfer shares;
• Obtain relevant and material information on the corporation on a timely and regular basis;
• Participate and vote in general shareholder meetings;
• Elect and remove members of the board; and
• Share in the profits of the corporation.

3. The Institutional investors, stock markets, and other intermediaries

‘The corporate governance framework should provide sound incentives throughout the investment chain and provide for stock markets to function in a way that contributes to good corporate governance.’

• All shareholders of the same series of a class should be treated equally
• Insider trading and abusive self-dealing should be prohibited
• Members of the board and key executives should be required to disclose to the board whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation.

4. The role of stakeholders in corporate governance

The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

5. Disclosure and transparency

The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.

6. The responsibilities of the board

The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.

Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. Cost allocation is also used in the calculation of profitability at the department or subsidiary level, which in turn may be used as the basis for bonuses or the funding of additional activities. Cost allocations can also be used in the derivation of transfer prices between subsidiaries.

Example of Cost Allocation

The African Bongo Corporation (ABC) runs its own electrical power station in the hinterlands of South Africa, and allocates the cost of the power station to its six operating departments based on their electricity usage levels.

Types of allocated costs

When allocating costs, it’s important to know the types of costs your organization associates with the selected cost objects. Here are some of the most common types of costs you may use in your cost accounting processes:

Fixed costs

Fixed costs are the expenses that remain consistent when other factors change. For example, the cost of rent or loan payments are fixed costs because they don’t usually change from month to month. Fixed costs are usually relatively easy to connect with specific cost objects, and they can be direct or indirect.

Variable costs

Variable costs change based on factors such as market conditions and production. For example, think of a toy company that produces a toy car featuring plastic pieces. If there’s a shortage of plastic material for a short period, the production costs for the toy may increase. In addition to production costs, other variable costs may include packaging supplies and delivery costs. Variable costs are often direct costs but can be indirect as well. For example, the cost of a utility bill may fluctuate depending on the weather.

Operating costs

Operating costs, which some people also refer to as overhead costs, can be either fixed or variable. They relate to a company’s daily functions. For example, operating costs can include sales, marketing and travel costs.

Direct costs

A business professional can connect a direct cost with an identifiable cost object. For example, you may consider the materials and labor that are necessary for a product’s production. These are direct costs because they result in a tangible cost object.

Indirect costs

Indirect costs are expenses that contribute to production without a direct connection to any particular cost object. For example, you can consider rent, utilities and office supplies. These costs are necessary for production, but a company doesn’t usually associate them with a specific cost object.

Cost Allocation Methods

The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or (as in the example) electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behavior patterns of the cost objects. Thus, an allocation method based on headcount might drive department managers to reduce their headcount or to outsource functions to third parties.

Cost Allocation and Taxes

A company may allocate costs to its various divisions with the intent of charging extra expenses to those divisions located in high-tax areas, which minimizes the amount of reportable taxable income for those divisions. In such cases, an entity usually employs expert legal counsel to ensure that it is complying with local government regulations for cost allocation.

Reasons Not to Allocate Costs

An entirely justifiable reason for not allocating costs is that no cost should be charged that the recipient has no control over. Thus, in the African Bongo Corporation example above, the company could forbear from allocating the cost of its power station, on the grounds that none of the six operating departments have any control over the power station. In such a situation, the entity simply includes the unallocated cost in the company’s entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost.

Cost Allocation Mechanism

Identify cost objects

The first step when allocating costs is to identify the cost objects for which the organization needs to separately estimate the associated cost. Identifying specific cost objects is important because they are the drivers of the business, and decisions are made with them in mind.

The cost object can be a brand, project, product line, division/department, or a branch of the company. The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects.

Accumulate costs into a cost pool

After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create several categories where the costs will be pooled based on the cost allocation base used. Some examples of cost pools include electricity usage, water usage, square footage, insurance, rent expenses, fuel consumption, and motor vehicle maintenance.

Benefits of Cost Allocation

Helps evaluate and motivate staff

Cost allocation helps determine if specific departments are profitable or not. If the cost object is not profitable, the company can evaluate the performance of the staff members to determine if a decline in productivity is the cause of the non-profitability of the cost objects.

On the other hand, if the company recognizes and rewards a specific department for achieving the highest profitability in the company, the employees assigned to that department will be motivated to work hard and continue with their good performance.

Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they can use in making decisions. It shows the cost objects that take up most of the costs and helps determine if the departments or products are profitable enough to justify the costs allocated. For unprofitable cost objects, the company’s management can cut the costs allocated and divert the money to other more profitable cost objects.

(i) Direct Re-Distribution Method:

Under this method, the costs of service departments are directly apportioned to production departments without taking into consideration any service from one service department to another service department. Thus, proper apportionment cannot be done and the production departments may either be overcharged or undercharged. The share of each service department cannot be ascertained accurately for control purposes. Budget for each department cannot be prepared thoroughly. Therefore, Department Overhead rates cannot be ascertained correctly.

(ii) Step Distribution Method:

Under this method the cost of most serviceable department is first apportioned to other service departments and production departments. The next service department is taken up and its cost is apportioned and this process goes on till the cost of the last service department is apportioned. Thus, the cost of last service department is apportioned only to the production departments.

(iii) Reciprocal Services Method:

In order to avoid the limitation of Step Method, this method is adopted. This method recognizes the fact that if a given department receives service from another department, the department receiving such service should be charged. If two departments provide service to each other, each department should be charged for the cost of services rendered by the other.

There are three methods available for dealing with inter-service departmental transfer;

(a) Simultaneous Equation Method,

(b) Repeated Distribution Method and

(c) Trial and Error Method.

(a) Simultaneous Equation Method:

Under this method, the true cost of the service departments are ascertained first with the help of simultaneous equations; these are then redistributed to production departments on the basis of given percentage. This method is preferable and is widely used even if the number of service departments are more than two. Due to the availability of computer it is not difficult to solve sets of simultaneous equations. Following illustration may be taken to discuss the application of this method.

Inter-Service Departmental Mutual Allocation System (Simultaneous Equation Method):

The method given above assumes that service is rendered by say, Repairs and Maintenance department to the Power House but not by the latter to the former. This assumption is not valid since service departments not only render service to production departments but also mutually. This fact should be considered while apportioning expenses.